Futures are a popular asset type for risk management. Investment risk can never be totally removed, but its influence may be minimized or passed on. Future agreements between two parties stretch back to the 1800s. In 1865, the Chicago Board of Sell established futures contracts to enable farmers and traders to trade grain and other soft commodities at future transaction dates throughout the year.
- Hedging is a risk-reduction strategy that involves holding an offsetting position in a closely comparable product or asset.
- Commodity futures contracts may be used to hedge by both consumers and producers.
- Hedging via futures essentially locks in a commodity’s price today, even if it will be purchased or sold in physical form in the future.
Let’s take a look at some fundamental examples of the futures market, as well as the potential returns and hazards.
For the purpose of simplicity, we’ll assume a single unit of the commodity, which may be a bushel of corn, a liter of orange juice, or a ton of sugar. Consider a farmer who anticipates that one unit of soybeans will be ready for sale in six months. Assume the spot price of soybeans is $10 per unit right now. He seeks a minimum selling price of $10.10 per unit once his crop is complete, after taking into account planting expenses and potential earnings. The farmer is anxious that oversupply or other uncontrolled circumstances may cause future price decreases, leaving him with a loss.
Here are the parameters:
- The farmer anticipates price protection (minimum of $10.10).
- Protection is required for a certain amount of time (six months).
- The farmer knows that he will produce one unit of soybeans within the specified time period.
- His goal is to hedge (to reduce risk/loss), not to speculate.
Futures contracts, by definition, fit the following parameters:
- They may be purchased or sold now in order to lock in a future price.
- They are valid for a certain length of time and then expire.
- The futures contract’s quantity is fixed.
- They offer hedging.
Assume a six-month futures contract on one unit of soybean is available today for $10.10. To get the necessary protection, the farmer might sell this futures contract (short sell) (locking in the sale price).
How This Works: Producer Hedge
If the price of soybeans rises to $13 in six months, the farmer will lose $2.90 on the futures contract (sell price-buy price = $10.10-$13.00). He will be able to sell his real agricultural product for $13 at the market rate, resulting in a net selling price of $13 – $2.90 = $10.10.
The farmer will gain from the futures contract if the price of soybeans continues at $10 ($10.10 – $10 = $0.10). He’ll sell his soybeans for $10, resulting in a net transaction price of $10 + $0.10 = $10.10.
The farmer will gain from the futures contract if the price falls to $7.50 ($10.10 – $7.50 = $2.60). He’ll sell his agricultural product for $7.50, for a net selling price of $10.10 ($7.50 + $2.60).
The farmer is able to protect his intended selling price in all three circumstances by utilizing futures contracts. The real agricultural yield is sold at market rates, but the futures contract eliminates price fluctuations.
Hedging does not come without expenses or hazards. Assume that in the first example, the price hits $13, but the farmer did not purchase a futures contract. He would have profited by selling for $13 more. He lost an additional $2.90 due to his futures investment. On the other hand, in the third scenario, when he was selling for $7.50, his condition might have been far worse. He would have incurred a loss if he had not had futures. In all circumstances, though, he is able to accomplish the intended hedge.
How This Works: Consumer Hedge
Consider a soybean oil company that requires one unit of soybean in six months. He is concerned that soybean prices would skyrocket in the near future. He may purchase (go long) the identical soybean future contract to lock in a buy price of approximately $10, say $10.10.
If the price of soybeans rises to, say, $13, the buyer of the futures contract will profit by $2.90 (sale price-buy price = $13 – $10.10). He will purchase the requisite soybean at the market price of $13, resulting in a net purchase price of -$13 + $2.90 = -$10.10. (negative indicates net outflow for buying).
If the soybean price stays at $10, the buyer will lose money on the futures contract ($10 – $10.10 = -$0.10). He will pay $10 for the needed soybean, bringing his net purchase price to -$10 – $0.10 = -$10.10.
The buyer will lose money on the futures contract if the price falls to $7.50 ($7.50 – $10.10 = -$2.60). He will purchase the needed soybean at the market price of $7.50, resulting in a net purchase price of -$7.50 – $2.60 = -$10.10.
By utilizing a futures contract, the soybean oil maker is able to get his desired purchasing price in all three circumstances. Essentially, the agricultural yield is purchased at market pricing. The futures contract smooths out price fluctuations.
The hedging needs of both the soybean farmer (producer) and the soybean oil factory (consumer) are addressed by using the same futures contract at the same price, quantity, and expiration. Both were able to secure their targeted price for future purchases or sales of the commodity. The risk was not transferred but rather mitigated—one was missing out on larger profit possibilities at the cost of the other.
Both sides may mutually agree on this set of established criteria, resulting in a future contract that will be fulfilled (constituting a forward contract).The futures market connects buyers and sellers, allowing for price discovery and contract standardization while eliminating counter-party default risk, which is prevalent in mutual forward contracts.
Challenges to Hedging
While hedging is advised, it does provide new obstacles and concerns. Some of the most frequent are as follows:
- Marginmoney must be deposited, which may be difficult to come by. Even if you possess the real commodity, margin calls may be necessary if the price in the futures market goes against you.
- Daily mark-to-market requirements may exist.
- In other circumstances, using futures removes the increased profit possibility (as cited above).It may result in differing impressions in big firms, particularly those with many owners or those listed on stock markets. Shareholders of a sugar firm, for example, may anticipate larger profits owing to a rise in sugar prices last quarter, but they may be disappointed when the released quarterly results show that earnings were negated due to hedging positions.
- Contract size and characteristics may not always meet the desired hedging coverage exactly. One contract of Arabica coffee “C” futures, for example, covers 37,500 pounds of coffee and may be too huge or disproportionate to meet the hedging needs of a producer/consumer. If small-sized mini-contracts are available, they may be investigated in this scenario.
- Standard accessible futures contracts may not necessarily correspond to actual commodity specifications, resulting in hedging disparities. If a farmer grows a different kind of coffee, he may be unable to obtain a futures contract that covers his quality, forcing him to settle for only accessible robusta or arabica contracts. His real selling price at the time of expiration may vary from the hedge available from the robusta or arabica contracts.
- If the futures market is inefficient and poorly regulated, speculators may dominate and significantly influence futures prices, resulting in price differences at entrance and exit (expiration), which undoes the hedging.
The Bottom Line
Hedging is now feasible for everything and everything, thanks to the introduction of new asset classes through local, national, and worldwide exchanges. Commodity options are a hedging alternative to futures contracts. When evaluating hedging securities, make sure they fulfill your requirements. Keep in mind that speculative profits should not tempt hedgers. Hedging may be accomplished with great planning and commitment.
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